Rerun of dollar unilateralism

Trump trepidation and European vulnerability

by David Marsh

Mon 14 Nov 2016

Donald Trump’s ascent seems likely to unleash on Europe a new and damaging form of dollar unilateralism – a peril the old Continent has periodically suffered since the 1960s, but has lain dormant for much of the past 35 years.

The approaching presidency of a go-for-growth ‘America-first’ businessman unschooled in any kind of diplomacy poses a grave potential threat to the cohesion of Europe’s economic and monetary union. In store is a probable shift in the US and Europe – disruptive rather than coordinated – to a long-championed goal of fiscal loosening and monetary tightening.

Trump’s mercantilist-protectionist leanings, espousal of economic populism and promises to shake up ties with America’s allies combine all the traditional ingredients for toxicity in transatlantic relations and none of the sources of stability. This could hit European exports to the US, one of the few factors supporting anaemic European growth.

If Europe is unlucky, it could be exposed to effects mirroring and even exceeding the worst past upheavals: Richard Nixon’s severing of the gold-dollar link in 1971, Paul Volcker’s drastic Federal Reserve tightening under Jimmy Carter and Ronald Reagan in the early 1980s, and the troubled aftermath of the 2008 Lehman Brothers bankruptcy under George W. Bush.

One of the main reasons for setting up EMU in 1999 as a culmination of a 30-year process of European currency co-operation was to protect Europe from exactly the kind of international monetary vicissitudes that now seem probable.

Europe has constructed impressive internal defence mechanisms since the European debt crisis in 2010, but large EMU imbalances remain, making the continent vulnerable to external tensions.

Europe has not been exposed to a full-scale dollar buffeting since the sharp rise in US interest rates that started with President Carter’s dollar support package in November 1978. This culminated in Fed tightening under Volcker – Fed chairman after August 1979 – that sparked concomitant interest rate increases in Europe. The monetary squeeze depressed growth and led to the political demise of three leaders: Carter in the November 1980 election, French President Valery Giscard d’Estaing in May 1981, and German Chancellor Helmut Schmidt in October 1982. Reagan, who took over from Carter in January 1981, ushered in a policy of ‘benign neglect’ of the dollar that may now resurface under Trump.

Another historical parallel is President Nixon’s election in 1968, which led to his naming Arthur Burns as Fed chairman in 1970 with the aim of easing conditions for growth and employment. In similar vein, Trump is expected to appoint an economic sympathiser as successor to Janet Yellen, whose four-year Fed chairmanship ends in February 2018, and whom he has already castigated as unduly complicit with President Barack Obama. Nixon’s Treasury secretary John Connally told America’s foreign counterparties, ‘The dollar may be our currency but it’s your problem’ – a phrase that may reappear under Trump.

Whatever Trump’s choice to head the Fed, discord between the White House and central bank seems inevitable in view of the independent nature of the rate-setting Federal Open Market Committee. The president-elect’s disregard for economic orthodoxy and his willingness to run larger budget deficits to fund tax cuts and infrastructure spending are likely to generate higher inflation. Longer term, this promises a volatile dollar veering between strength and weakness. In the shorter term, it could scupper the European Central Bank’s bond-buying programme at a sensitive time, shortly before the ECB decides on the next stages of quantitative easing on 8 December.

Taking pride in his non-existent experience in political office, Trump is likely to take an uncompromising line on Europe’s weaknesses. Ahead of electoral tussles in the next 12 months in Italy, the Netherlands, France and Germany, Trump could lay bare fault lines among European populations similar to those that have promoted his rise in America.

Central bankers have worried for some time that an otherwise welcome international growth revival would depress inflated bond prices and confront central banks with substantial losses on government securities acquired during bond-buying sprees since 2009. Europe is particularly exposed, since the ECB started buying only relatively late, in March 2015, at a time when bond prices were already very high.

A sharp rise in sovereign yields in Europe and the US since Trump’s win last Tuesday, together with an increase in euro area inflation expectations to an eight-month high, will buttress opposition on the ECB’s governing council to an extension in ECB quantitative easing beyond March 2017. The Bundesbank’s anti-bond buying strictures have been reinforced by a warning on 2 November from the German government’s council of economic advisers that ECB policy is ‘neither appropriate for the euro area nor Germany’. A mix of Trump trepidation and higher inflation will certainly stoke conflict over ECB QE – and many still more bruising battles lie ahead.